Uncoated Paper's Strong Arms

Uncoated freesheet producers suffered least over the past year of soft pricing and weak demand, but they seem to be taking the toughest stands into the first quarter of 2002.

The business is besieged by electronic competition, postal rate increases, a poor business spending climate, and an influx of cheap Brazilian imports. Uncoated freesheet has remained a very competitive U.S. product because of available resources to wood pulp (integrated facilities), close proximity to big markets, and a growing service economy.

Unfortunately, the industry is not able to secure a return equal to or greater than the cost of capital, so its mills are withering. Permanent closure of nearly 10% of capacity was recorded over the last two years in the U.S., yet imports are now capturing nearly 6% of consumption.

Recent corporate developments reveal that U.S. parent companies are not standing still in the face of this industry malaise. Belt tightening, strong arming, and brute force all are being employed to secure future market positions. The industry may not be able to stop the slow erosion of market demand of its volume, but it can pull internal strings to maintain some economic balance and survive.

The sale of timberlands, once the backbone of every integrated forest products company, has been unprecedented over the last few years. Last year alone, 1.7 million acres of timber were sold to raise about $1.5 billion in cash, mostly to pay off financing arrangements from merger and acquisition activities.

This year, with the completion of at least one and perhaps two large mergers, another two million acres are likely to change hands. The paper industry's share of land ownership in the U.S. has been cut in half, which should placate environmentalists and preservationists (although through no efforts of their own, as it came about via simple economics).

The industry simply doesn't need the fiber anymore. It uses wastepaper and second- and third-generation stands. With decreasing demand for fine papers, massive paper machines like those used for uncoated freesheet will not be built anymore.

The other reason that timber is no longer a core asset is because of accounting rules. The paper industry contends that generally accepted accounting principles do not recognize the asset quality of growing or standing forests. Many timberland sales have been made to company-owned or solely owned forest companies, thereby making accounting procedures work as they consume their inventories.

Paper companies also are getting out of anything that does not fit into their paper-producing portfolios. International Paper (IP) had been an investor and owner of printing machinery companies and film producers; Mead made office supplies and business accessories like library resources; and Weyerhaeuser sold engineering services like thermal mapping technology.

Several others, primarily in the container board areas, sold off plastic packaging, flexible packaging, folding carton plants, and anything that didn't lead their paper from the machine to the consumer.

The more serious implication of the new industry structure revolves around the control of distribution channels. In the past, paper companies would manage inventory and let distributors guide the consumer in pricing and supply, lopping of a healthy 4% or so for services rendered. Now, paper makers either own or control distribution with a strong arm.

Contact with the independent merchant is becoming a distant memory. In the uncoated freesheet market, paper mills now control almost 80% of all product placement of what they produce. Boise Cascade Office Products, Unisource, xpedx, and others now are all owned by paper companies. Smaller merchants on both coasts have also sold out or accept dominance by paper mills.

The most popular and profitable merchants today are the odd lot and job-size houses like Case and Roosevelt in the East and Coastal and Splicers in the West. Their major competition is the on-line merchant, and that battle seems to be settling on what should be a key element in any sale: service. Those that do not require service simply bid on line, while those that want supplier contact use the phone and personal visits.

The heavy impact from the loss of independent merchants is not found in product mix or service (which tends to get wider), but on the bottom line. Mills now can exercise complete control in the pricing of their product without regard to local market conditions. With the concentration of product in so few hands, inventory balancing becomes much easier. The strategy: idle the paper machines until excesses recede.

IP recently announced solid price floors—nothing under $40/cwt—for merchants to follow in uncoated freesheet product. This acts to increase prices across the board to levels that cover costs. Most businesses will see costs for paper increase in 2002 for copier grades, duplicator and small print jobs, and most technical specialties.

Premium uncoated producers have divided the market into price points that keep fairly firm in any economic cycle, so prices for letterhead, stationery, and envelope stocks will remain largely unchanged this year.

With IP and Domtar taking on the largest groups of uncoated paper production in North America, and Mead and smaller companies exiting the business altogether, one would think that there should be no one left standing for consolidation.

Wrong. Forest products giant Weyerhaeuser, the largest private land owner in North America, has been pursuing a costly and somewhat brutal takeover attempt of its Pacific neighbor, Willamette Industries. In a shareholder vote in early January, only 64% was tendered for a bid that was increased by 10%. It would have been less except for the death of a founder's wife, an event that scrambled a chunk of shares.

The battle is a classic power play between rival companies with different business models and philosophies. For paper buyers, it could signal a new burst of capacity on the open market.

Weyerhaeuser has increased its uncoated freesheet business primarily in the offset roll area with good products and low prices sold through merchants. Willamette consumes nearly all of its paper through internal converting operations, with buyers recognizing the value in either good, cheap copier paper or low-price, high-value rolls for digital operations that they can buy direct or through distributors.

The merger may be coming to fruition; on January 29, Weyerhaeuser and Willamette signed a definitive merger agreement, creating a $19 billion forest products entity. Willamette's paper may enter the market through Weyerhaeuser's distribution network, pressuring prices and channels. However, further consolidation would push up the share of Weyerhaeuser's uncoated sheet holdings, giving total control of the market solely to itself, Domtar, and IP.